Understanding the market’s volatility

Last Friday’s US third-quarter growth figures surpassed expectations while inflation held below the consensus forecast. There was a time when this would have been enough to send Wall Street soaring, a dream scenario of strong growth and low inflation that recalls the famous Goldilocks economy of the late 1990s. Actually, the current scenario is closer to a nightmare: the stock market fell sharply again, pursuing a bearish trend initiated several weeks earlier. For an economic understanding of these trends, it is worth comparing equity market behaviour with that of the other asset classes, an exercise that is all the more difficult given that the correlation between asset classes tends to increase as pressures rise. Does the decline in long-term rates reflect a flight to safety more than a reassessment of the medium-term outlook for monetary policy? This would be reassuring since this outlook is closely linked to economic growth expectations. Looking at the corporate bond market, we are left with the same feeling of serenity concerning the level of GDP growth: the spreads between high-yield bonds and US Treasuries have certainly increased, but they are holding within the relatively narrow channels that have prevailed over the past several years. This is also an encouraging sign since the yield spread is highly correlated to the economic cycle: when growth is expected to slow sharply, fears of a significant increase in corporate bankruptcies drive up corporate yields relative to government bonds. The absence of a big spread widening suggests that investors do not fear a significant upturn in corporate bankruptcies.

We can take this analysis a bit further by looking at the volatility of equity and bond market performances. We are no longer looking at whether the equity and fixed-income markets are trending downwards. Instead we are trying to verify whether the ups and downs are occurring at a rapid pace. If this is the case, it would reflect a rapid reassessment of the factors that determine equity and bond prices, a movement that can be considered to express uncertainty and a lack of conviction on the part of investors. This is important for two reasons. First, uncertainty rhymes with high risk aversion: uncertainty risks having a lasting impact on equity returns. Second, research shows that after a certain lag, a period of high volatility is often followed by a slowdown in growth. In other words, equity market volatility is a good leading indicator of the economic cycle. This relationship can be attributed to volatility’s impact on the cost of financing and on the appetite for risk, both in the real sphere (corporate investment; household investment and consumption) and in the financial sphere.

What conclusions can we draw from all this? First, 2018 marks the year of renewed equity market volatility, with high peaks in February and also more recently, albeit to a lesser extent. In contrast, the volatility of long-term rates has barely budged and remains low. The same can be said for high-yield bonds. Apparently the close correlation that prevailed in the past between the volatility of equity markets and high yield bonds has declined sharply. There are several possible explanations for this uncoupling:

the complacency of corporate bond investors (but then we must ask why?),

the changes in interest rate and growth prospects were not the key factors behind equity market movements,

equity investors are extremely nervous and tend to overreact to macroeconomic data more than high-yield investors,

recent equity market behaviour is guided by uncertainty over individual corporate results rather than macroeconomic developments.

Given the recent disappointment over certain corporate results, we should probably favour this later explanation. What seems to be driving the markets is not macroeconomic fears but rather microeconomic disappointment.